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Have central banks run out of ammunition

The ECB will be holding a long-awaited interest rate meeting on Thursday – but what exactly is the role of the central banks, and what can they do now to kick-start growth? Danske Bank's investment strategist, Lars Skovgaard Andersen, examines these issues.

If central bank bosses are the global economy’s supermen, falling growth and low inflation are their
kryptonite. Put simply, the primary role of central banks is to maintain stable prices and stable growth by
their actions in the financial markets – but getting the desired effect is proving elusive.

Europe, the US and Japan are awash in low and often negative interest rates as a direct result of the central
banks having done all in their power to stimulate the economy; first by lowering policy rates since the
financial crisis in 2008/09 and subsequently by cranking up the money supply and buying up government and
corporate bonds.

Yet, since the financial crisis, it has been incredibly difficult for the central banks – especially in Europe
and Japan – to get inflation up to the desired target of around 2%, which is estimated to be the most favourable
for economic growth and stability.

What the toolboxes look like

Central banks have traditionally had two tools to adjust, steer and stabilise the economy, depending on whether it
was overheating or running cold:

Policy rate, which dictates which interest rate banks such as Danske Bank can borrow
money from the central bank at. The lower the interest rate, the cheaper it is for banks to borrow and thus
pass the money on to companies and consumers.

Reserve requirement, which dictates how much liquid holdings the banks should have in
order to weather economic storms. The lower the reserve requirement, the more money banks can send out into
the economy in the form of corporate loans, housing loans, etc. which support growth.

However, since the financial crisis, the European Central Bank (ECB) and the US central bank (Fed) have
expanded their toolboxes and carried out what we could call ‘market operations on steroids’ in the form of
so-called quantitative easing (QE) on a scale the world has not seen before.

Logic of QE

Quantitative easing involves the central banks buying bonds from banks,
which thereby get more money to dispense to companies, consumers, etc. – and the more money they have available,
the less interest the banks will charge for lending. Since the end of 2008, the ECB and the Fed have together
pumped out an amount equivalent to more than DKK 43,000bn into the economy, which in turn has sunk interest
rates to levels previously unheard of.

The Japanese central bank has in fact the longest history with non-traditional monetary policy. Policy rates in
Japan were already at zero by February 1999, and the central bank commenced QE in March 2001, buying up not only
bonds, but also equities.

What will central banks do now?

But it has all seemingly been no real help – or perhaps
it just hasn’t helped enough. Growth is still low in Europe and Japan, and inflation is still below target in
many countries. So naturally the big question is: what can central banks possibly do now to boost growth and
inflation? While there is no single answer to that question, we nevertheless see some potential actions for
central banks going forward – and they will probably be a mix of old and new:

Very likely options:

Restart QE: We expect one of the first things central banks will do is to restart and
intensify buybacks of the most secure government and corporate bonds. This will pump more liquidity into
the economy and help lift bond prices and thus sink yields further – or at least keep them low for a
long time yet. We expect the European Central Bank to announce the restarting of its buyback programme
at its meeting on 12 September.

Lower policy rates: We expect the ECB to cut interest rates by 20 basis points at the
September meeting, and that the US Fed will cut rates five times over the next five interest rate
meetings between now and March 2020.

Likely new measures:

‘Tiering’ or differentiated interest rates. One of the major problems with negative
interest rates is that the banks actually have to pay the central banks to have their reserve
requirements on deposit, which increases the banks’ costs and paradoxically the level of uncertainty in
the bank sector. We expect the ECB will discontinue the negative rate on the reserve requirement and
only maintain it on the money that the banks deposit in the central bank in addition to the reserve
requirement. (When banks have a deposit surplus, ie, when deposits are greater than lending, banks may
need to place money in the central bank).

Unlikely (But interesting) measures:

Helicopter money. Very simply this means the central banks depositing money directly into
your account and my account in order to stimulate consumption. This would again kick-start the economy
and lift inflation. This is a very unusual tool, but it has attracted increasing attention in recent
years because the current tools of the central banks do not seem to work sufficiently well.

Just how much out-of-the-box thinking the wise ones at the central banks can come up with is anybody’s guess.
However, one thing we are quite sure about at Danske Bank is that the role of the central banks should not be
underestimated – and we expect to see vitamin infusions from the central banks continuing for quite some time
yet in order to support growth and inflation.

Danske Bank has prepared this material for information purposes only, and it does not constitute investment advice. Always speak to an advisor if you are considering making an investment based on this material to establish whether a particular investment suits your investment profile, including your risk appetite, investment horizon and ability to absorb a loss

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